The attention of the whole investment world seems to be completely focused on the possibility of the U.S defaulting on its debt. These can be scary times for long-term equity investors, with 2008 still fresh in most investors' minds. But we believe investors should learn to look beyond these government-inflicted problems, and instead focus more on the future, as we are convinced it won't default.
Based on these and other macroeconomic developments, a 2% GDP growth in 2013 seems quite likely. Based on strong trade data, estimated second-quarter growth was revised up for most sectors. However, recent data suggests less near-term momentum in demand, so the projected second-half growth has been revised down from 2.6% to 2.2%.
The unemployment rate is likely to edge lower, balancing modest monthly employment gains and a steady labor force participation rate over the next few years. Employment gains through year-end 2013 should average roughly 160,000, reflecting sluggish GDP growth. The unemployment rate fell to 7.3% in August and is likely to average that in the second half of the year, before declining to 6.9% in Q4 2014 and 6.3% by Q4 2015.
Core consumer price inflation (PCE) appears to have bottomed at 0.8% in the second quarter, as most analysts expected. The core PCE inflation is likely to be around 1.3% over 2013, rising to 1.5% in 2014 and 1.8% in 2015. The gravitational pull from stable long-term inflation expectations near 2% and waning slack contribute to an upward trend in inflation over the next two years. The Fed might pump in about $1¼ trillion of QE3 with no funds rate hikes until mid-2015. Additionally, the Fed might begin tapering QE3 sooner rather than later. This should be seen as a bullish sign, as it is an indication of economic strength. QE3 hasn't stimulated growth and the money is for the most part sitting on the balance sheets of large banks. It's not making its way into the economy.
As far as the short rate goes, the FOMC's rate guidance seems reasonable enough, which calls for no further rate hikes, at least as long as the unemployment rate remains above 6.5%.
The Resilient U.S. Economy
In light of the challenges it has faced, the US economy has remained remarkably resilient. The list of challenges is a laundry list of macroeconomic gloom: financial headwinds, uncertainty out of Europe, fiscal drag, and a "premature" rise in long-term yields.
Despite these challenges, we currently estimate that GDP advanced at a 3.0% annual rate in the second quarter. The resilience of the US economy owes largely to solid gains in home and equity values last year and so far this year. These developments have bolstered consumer spending, even as real disposable income took a large hit this year from higher taxes. Support from rising household wealth and waning fiscal drag are expected to raise GDP growth to 2.6% in the fourth quarter.
Most analysts now believe S&P 500 companies will report earnings growth on a year-over-year basis for the third quarter of approximately 3 %. At the beginning of the year the projections were closer to the 10 % range. Slowing earnings growth could cause more volatility in the market, but looking ahead we believe corporate America is going to turn the corner, going from modest growth to a more accelerated pace. The possibility of a potential profit margin compression, however, still remains. Despite this drawback, if the economic recovery continues at the projected pace, earnings should trend upward which would be a positive for the market.
Most CEOs tend to under-promise and over-deliver when it comes to earnings. While earnings growth will probably be sluggish, it's very possible to beat dour expectations. We expect earnings growth to accelerate in the fourth quarter and into 2014.
The S&P 500 is a balanced global index - 45% of company revenues are earned abroad. Europe's economies rose out of a 22-month recession about three months ago. Manufacturing PMIs broke 50, the expansion number. September Eurozone composite PMI's were strong at 52.2. Japan's QE has rekindled strong GDP growth. China's +7.5% annual growth is picking up industrial strength. It might do +7.8% now. The fact that the global economy seems to be moving out of a recession will likely be a benefit for multi-national large-cap stocks.
The remaining 55% of U.S. S&P 500 earnings doesn't directly shoulder "global" risk. We remain optimistic on U.S. stocks overall. Our worries, and that of many investors, hail from a potential earnings slowdown caused by a light recession. Additionally, a major concern is that interest rates rise much faster than expected, hurting both fixed income and stock prices. However, right now the odds are far greater that rates remain relatively low and the expansion remains in place.
What compels this U.S. optimism? Simply put, the stock market highs have done a lot to stimulate discretionary purchasing. In addition, serial strength flowed deep into the U.S. housing market, and then moved deeper into augmented value chains, positively impacting business profits and finance. We have seen U.S. housing contribute to GDP growth quarter after quarter for some time now. That Achilles heel was safely put behind us. Different business segments including real estate, banks and autos led the way. But the taper's ghostly presence slowed new home sales and refinances down. A good U.S. housing story must be part of an ongoing recovery. We do believe that housing prices should continue to modestly advance, helping strengthen the recovery.
Putting It All Together
While we expect the market to suffer from some turbulence in the near future as the government argues over the debt ceiling and the government shutdown, we believe the long-term outlook is bright. The stock market may be poised for a final rally before the year ends. Once all the chatter about defaults and shutdowns is behind us, the market could benefit from the upside surprise of earnings beating estimates and a resolution to the debt ceiling fighting. We remain bullish on stocks for long-term investors. Investors should view any downturn we experience as a good buying opportunity, instead of rushing to sell.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Syncopy Research is a team of financial analysts. This article was written by Alex Kimani, the company’s Senior Analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article